2012: Another Year of Uncertainty & Volatility

FORECASTS & TRENDS E-LETTER
by Gary D. Halbert
January 3, 2012

Introduction

Given the hectic New Year’s weekend at the Halbert home, there was little time for reading or working on today’s E-Letter. If I counted correctly, we had 24 for dinner on New Year’s Eve and even more for the fireworks show that followed. Every bed and several sofas in both houses were occupied overnight, and the last of the family and friends did not depart until yesterday afternoon. While tiring and at times a little hectic, it was great fun.

For today’s letter, I have selected two articles that I found interesting reading as we all try to figure out what may lie ahead in 2012. I will get back to my usual chorus of titles and topics starting next week. As a hint, I believe that 2012 has the potential to be the most dangerous year we’ve faced since 2008. Why?

The European debt crisis is far from over and a banking crisis there is certainly not out of the question. America may not be far behind, especially given that foreigners unloaded a record amount of US Treasury debt in December. I’ll have more on that just ahead. Then there is the Middle East where Egypt, Syria and Iran are all under the control of extremists.

I could go on with risks we face in 2012, but you get the idea. I expect 2012 to be a very challenging year for investors. As I have done for many years, I will continue to present you with ideas and strategies to consider. As always, I thank you for your faithful readership and remind you that your comments and suggestions are always encouraged. Happy New Year!

With that said, we begin today with an interesting piece from yesterday’s The Weekly Standard which argues that the outlook for 2012 comes down to your assumptions:

A Gloomy New Year's Forecast
by Irwin M. Stelzer

Now that you have read the results of the various economic forecasting models that have served so many so badly in recent years—they are predicting the U.S. economy will grow in 2012 at an annual rate of between 1.5 percent and 2 percent—let me offer an alternative way of looking at things. It is called ‘pick your if.’

If you believe that the recent decision of the European Central Bank to make unlimited cash available to eurozone banks for the next three years, and that the meeting next week of German chancellor Angela Merkel and French president Nicholas Sarkozy will solve the problems created by excessive debt of some eurozone countries, you will heave a sigh of relief. You will then not have to worry whether the inevitable Greek default will be the first step towards a Lehman Brothers moment, with liquidity drying up, bank credit shrinking, and a deep recession settling over Europe, hurting American banks and exporters.

If you believe that the recent jagged but downward trend in claims for unemployment insurance foretells a drop in the unemployment rate that will be reported on Friday, and if you give weight to recent cheery numbers such as the uptick in regional indices of economic activity, you will stop worrying about the possibility of a renewed collapse in the jobs market.

If you read the recent upsurge in consumer confidence and spending to be suggesting that the demand side of the economy is ready to contribute to a more rapid recovery, you will murmur a word of thanks to the sainted John Maynard Keynes, and face 2012 with equanimity.

If you think that the combination of increased home sales and housing starts, and record low interest rates means that the housing market has bottomed out, as investors who have driven up builders’ share prices believe, you will contact your favorite real estate broker to inquire about a new, bigger home, or move out of your parents’ home and into your own starter property.

If you think that the presidential and congressional elections will end the stalemate that has seen U.S. debt soar to levels that have the rating agencies on edge, you will have renewed faith in the democratic process. A reelected, newly conciliatory Barack Obama will find the political center attractive, and Republicans in Congress will abandon their defense of “the rich” from the higher taxes the Democrats want to impose. The White House version of tea and sandwiches will produce a new harmony and compromises acceptable to the president’s trade union supporters and the Tea Party. If you believe all of this, you should be looking forward to a better 2012, which is what a recent poll shows is the expectation of 62 percent of Americans, and an even better 2013.

Alas, there is another set of “ifs” to consider. If the eurozone problem remains unresolved, as it might, Europe’s banks will totter and perhaps trigger a global cash crunch. After all, even after the ECB’s buying binge Italy still finds itself paying close to 7 percent for loans. A major European recession would follow. If you believe demand for China’s exports will continue to weaken, and that its banks can’t off-load some $2 trillion in bad loans, then you believe that China’s demand for commodities and Western products also will weaken, removing that source of strength from the world economy.

If you believe that the continued fall in house prices—down in October for the 13^th consecutive year-over-year decline—is more significant a harbinger than the recent modest pickup in sales, you also believe experts who guess that the bottom of the housing market will not be reached until 2015. That bodes ill for the jobs market: The Federal Reserve Board’s economists expect the unemployment rate to stay at around its current level of 8.6 percent, which means that 24 million Americans will be out of work, looking for full-time employment, or too discouraged to bother hunting for a job.

If you believe that the recent spurt in consumer spending will prove unsustainable because it has come at the expense of savings—the savings rate has dropped from around 5 percent to a mere 3.5 percent—you believe the demand side of the economy will remain too weak to sustain the [some expect] fourth quarter 2011 growth rate of between 3.5 percent and 4 percent.

If you believe that the new round of regulations being readied by the Obama administration for the new year will frighten businesses, especially job-creating small businesses, you also believe that business investment is unlikely to provide much of a boost to the economy. Onerous new reporting requirements, covering everything from the value of minerals purchased from the Congo to the value of employee health care plans are on tap. As are regulations still being drafted to implement new statutory regulation of financial institutions, and impose new environmental clean-up costs on utilities and manufacturers.

If you believe that the fiscal follies in Washington will lead to a further downgrade of U.S. debt, and a possible rise in interest costs, you worry that such a move will convert fragile growth into a double-dip. Or that deficits will continue to mount, the Fed will print money to pay America’s debt, and Jimmy Carter-style double-digit inflation will again wipe out savings and distort investment patterns. Stagnation or inflation or both—stagflation.

To each his own set of “ifs.” My own view might well be excessively colored by being in Washington, where rancor and recrimination substitute for reasoned debate, where the president has become a general in the new class war, and the Republicans refuse to recognize the need to reform market capitalism, where politicians seem intent on adopting the fiscal policy of southern Europe. So I incline to short term gloom, although I will not be surprised if the consensus forecast of 1.5 percent - 2 percent growth in 2012 is exceeded a bit—a continuation of the jobless recovery.

But longer term the outlook brightens. America is still the world’s largest source of major innovations. It remains the home of risk-taking venture capitalists, deep and liquid securities markets, and a labor market so flexible that thousands can flee, and indeed are fleeing high-tax, regulation-heavy, union-ridden California for booming Texas. It is a safe haven for investors and the country of choice by immigrants. And so it will remain.

Whatever your “if,” I wish you a happy, or at least not an unhappy, new year.
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Our next article is one published yesterday by financial writer Barry Ritholtz who is chief executive of FusionIQ, a quantitative research firm, and the author of the popular book,“Bailout Nation.” Barry pokes some fun at the many New Year forecasts we all hear this time of year, and he points out that most of them prove to be wrong.

Investing in 2012: Forecaster Folly
by Barry Ritholtz

The new year has arrived, and so investors are inundated with all manner of lists: Best and worst stocks for 2012, forecasts of where the economy is going, favorite investments for the year and more.

What’s an investor to do? You should start by ignoring those lists. Let’s conduct a little experiment to demonstrate why: Do a quick Google search for “where to invest in 2011.” I read through the first dozen or so. For the most part, the performance was pretty awful. Before the excuse-making starts — 2011 was an unusual year, the ECB/Fed intervened, etc. — let me clue you in to this fact: Forecasters are pretty awful every year.

Whenever I see one of those “Buy this now for the new year” columns, I diary them in my calendar or use the free Web site Followupthen.com. A year later, I look back at these recommendations and forecasts, and, for the most part, they’re terrible.

Because of this folly of forecasting, I try not to make many predictions. Whenever I am asked where the economy is going, who is going to win that year’s elections or what the markets are going to do, I steal a trick from the weatherman: Always couch your forecasts in probabilities. That way, when I am wrong — and anyone who pretends to know what will happen in the future will frequently be wrong — at least I can declare the outcome was an anticipated probability.

“As we stated last January, there was a 10 percent chance that the Federal Reserve’s Hobbensobbers were going to be trounced by the bond market’s Rebblesacks — and that’s exactly what happened!”

It’s a great cheat to avoid saying silly things in public that could come back to haunt you.

These are my 10 forecasts as to what the forecasters will be forecasting for 2012:

1 Stocks will trounce bonds this year: We heard this one a lot in 2010; it turned out to be wildly wrong. Stocks were flat in 2011, while bonds gained about 13 percent. Indeed, turning conventional wisdom on its head, bonds have outperformed stocks the past one, 10 and 30 years.

Hey, maybe stocks will beat bonds next year. If you keep making the same prediction, eventually it will come true.

2 Housing has bottomed: A perennial favorite from the usual suspects, who have been consistently, insistently and persistently wrong about this since residential real estate peaked in mid-2006. As the most recent Case-Shiller data show, home prices fell another 3 to 4 percent in 2011. From prices that remain too high to an excess of inventory to slow household formation, there are many reasons the bottom has not yet occurred.

3 Election forecasts: In politics, six months is a lifetime. Just look at how often the poll leader has shifted in the Republican nomination race over the past six months. Making a forecast 11 months out about politics is sheer folly. But consider: Lots of people will make forecasts about who will win the primary, what the final tickets will look like, who needs to win which states to gain how many electoral votes. The sheer number of forecasts means that someone will, if only by chance, get it right.

4 Buy these 10 stocks: You must buy THESE 10 stocks — not those 10 stocks or even these 10 stocks, but THESE 10 stocks. Looking back at all of these lists, it is surprising more people didn’t get something right, if only by accident.

The question investors should be asking themselves is why am I buying stocks at all and not simply indexing? Answer: Makes for too short an article.

5 The economy is better than the data suggest: We see this over-optimistic discussion every year. It is consistently wrong. If anything, data about the economy tend to overstate growth, employment and sales while understating inflation.

There is a period when the economy is better than the data show it to be: At troughs, when a long downturn is reversing itself. Are we at that sort of a juncture? Considering it has been nearly three years since the market lows of March 2009, and 30 months after the recession ended in July 2009, that hardly seems to be the case. The economy was better than the data implied in mid-2009, not today.

6 The Apocalypse is coming! This is the over-pessimistic view. Yes, we know, the end is near. You tell us this year after year, and it is terribly tiresome. After the Apocalypse, you have full license to say “I told you so.” Until then, please go away.

7 Banks will come roaring back: My favorite terrible forecast for 2011 was “Buy the Banks” (NYSE: XLF); a variant was “buy Bank of America” (NYSE: BAC). And just how well did that work out? The financial sector was among the worst performers of the S&P in 2011. In a year when markets were flat, financials fell 20 percent. As to Bank of America, it collapsed 60 percent, in percentage returns, the worst forecast of the year.

Every year some value managers come out pounding the table on whatever sector got beat up that year, regardless of the reasons for it. They are always sorry to learn that mean reversion is not tied to a calendar.

8 Hyperinflation: During the 2000s, we hardly heard forecasters say much about inflation. You might recall that during that decade, oil rallied from $20 to $147, foodstuffs skyrocketed, and education and health-care costs had double-digit annual gains.

Post-credit crisis, the economy has been in a deflationary mode. Asset prices are flat-to-negative, labor utilization is way below trend, and demand for goods and services remains soft. No matter how much money central banks print, these are not the factors that lead to Weimar Republic-like hyperinflation.

9 Buy gold: On a related note, the gold bugs got some comeuppance this year. As of mid-August, gold had gained more than 33 percent year to date (according to the gold-tracking ETF: NYSE: GLD). But the enthusiasm for the trade got way ahead of itself, and gold lost more than a quarter of its value, with GLD falling $46.59. After a spectacular decade of gains, the shiny yellow metal failed to achieve gains of even 10 percent in 2011 and was outperformed by bonds.

10 Buy emerging markets: Mulligan! This was another favorite forecast for 2011, and it was wildly wrong. China and Hong Kong were down 20 percent; India and Brazil were off by a third. The decoupling thesis never goes away — that despite the interconnected global economies, some regions will do well even when their biggest trading partners slide into recession.

The key thing you should remember when it comes to investing is that nobody truly knows what tomorrow will bring. Nobody. These predictions are, at best, educated guesses. Yesterday’s predictions are undone by tomorrow’s news. Circumstances change. New economic data are released. Unanticipated events unfold.

All good reasons to avoid forecasts altogether.
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Wishing you all the best in 2012,

Gary D. Halbert